Why Harvey Norman has run out of steam

Nathan Bell

Hold your stones. What I’m about to write may sound like value investing heresy. I’m about to recommend you sell Harvey Norman – largely because it has a strong balance sheet and an owner manager.

We typically love these characteristics. They help companies maintain a long-term perspective, providing shelter to ride out short-term storms. But when a storm turns out to be a tsunami, then shelter may not do you much good; it would be better if you were a little less comfortable and were forced to seek higher ground.

The internet has unleashed a tsunami on the retail industry and it won’t work to bunker down and wait for it to pass. Unfortunately, for the retailers – though perhaps fortunately for shoppers – there don’t appear to be any easy answers. But with Harvey Norman owning a large slab of its properties and having a husband and wife team as chairman and chief executive, owning over 30 per cent of the shares, it doesn’t appear to be asking the tough questions.

But before expanding on why we think Harvey Norman’s best days are behind it, let’s give credit where it’s due.

Gerry Harvey is clearly a smart bloke. The stack ‘em high sell ‘em cheap model integrated with direct property ownership and franchising has been extremely successful. It’s a business model that, until recently, has served everyone – customers, suppliers and shareholders – very well. Fortunes have been made.

New model needed

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That model, though, appears to have had its day. According to a recent study by Fleishman-Hillard, 97 per cent of shoppers research purchases online and trust recommendations from the internet over family and friends. The internet is the tool for research pre-purchase and increasingly the point of sale.

The effect is twofold. Salespeople in bricks and mortar stores have a diminishing role to play; while more transparent pricing makes their job doubly hard.

The online retail model has also lowered operating costs. Renting a warehouse near a freeway and selling through a website is far less expensive than renting space in hundreds of shopping centres, fitting them out, filling them with stock and staffing them with friendly salespeople.

The internet has enabled a better business model. We can more easily buy things we want, when we want them, for a lower price.

Electronics and computer sales are among the hardest hit – because there’s little a shop worker can add to what’s said about them online – and they account for around 40 per cent of Harvey Norman’s sales.

Even categories less exposed to the online threat – such as furniture, bedding and white goods (which comprise 50 per cent of Harvey’s sales) – are being threatened by global operators such as IKEA and new chains such as Woolworths’ Masters. Even JB Hi-Fi has expanded into white goods and home appliances.

Retail has always been and will always be competitive. But it’s getting tougher, and it’s hard to see Harvey Norman maintaining its market share in such an environment.

These structural threats say nothing of cyclical ones such as housing starts and unemployment. Australia has enjoyed a huge, once in a generation, resources boom. This has boosted employment and incomes across the land, helping us buy new houses and fill them with shiny TVs and plush couches.

But the boom is busting and, despite the likelihood of a short-term uptick in retailers’ performance this Christmas thanks to record low interest rates and the resultant frothy housing market, we can’t see the next decade being anywhere near as favourable for retailers as the last.

Where’s Harvey to go?

So Harvey Norman’s valuation needs to be considered against this gloomy backdrop.

The company can be thought of as three interrelated businesses – its 77 company owned stores, its 206 franchised stores and its $2.2 billion property portfolio. Let’s start by estimating the value of the property.

Harvey Norman owns 102 of the 283 sites it operates (under its various brands: Harvey Norman, Joyce Mayne, Domayne, and Space), primarily the non-shopping centre based sites in Australia and New Zealand. These properties are mostly tenanted by Harvey Norman franchisees.

The portfolio has a balance sheet value of $2.2 billion, based on market valuations. Based on our broader views about property valuations in this country, we’d consider this to be on the generous side. We’d estimate fair value for the portfolio to be closer to $2 billion, and a cheap valuation of $1.5bn.

So what about the remaining retailing business? Harvey Norman will likely see some respite in the current half thanks to a better-than-expected Christmas period, but the longer-term trend is unlikely to reverse.

We estimate that rent-adjusted earning before interest and tax (EBIT) could swing between $100 million and $300 million over the next few years depending on the economic environment. All things being equal we’d be willing to pay a higher multiple when EBIT is closer to $100 million and a lower one when it’s closer to $300 million. All in all, we’d suggest a value of between $1 billion and $1.5 billion for the retailing business.

Adding on the property value of between $1.5 billion to $2 billion and deducting net debt of $659 million we arrive at an equity value of $1.8 billion – $2.8 billion, or $1.73–$2.67 per share. That’s well below the current market price of $3.26. Or, to put it another way, the current market price assumes retailing profits will rebound and be sustainable. We have our doubts.

Fightback?

Hold up though. Doesn’t Harvey Norman have one of the best retailing brands in the country and the balance sheet strength to fight back?

Yes and no. As we’ve already explained, the property portfolio that underwrites the company’s value, and protects shareholders from a catastrophe also allows it to be lazy. A highly indebted retailer would have to adapt or die. Harvey Norman can afford to move more slowly.

The property portfolio and the relationship with the franchisees also means it’s hard for it to adjust its business model. If Harvey Norman decided it needed fewer stores, for example, to whom would it sell them? And for what use?

The balance sheet strength also gives it the firepower for a costly and value destructive price war.

Repositioning the business for success will be tough. Although we’re impressed with management’s recent refocusing on service, over price, and development of a decent online store, it’s probably a case of too little too late.

We also fear that the man who built the empire – Gerry Harvey – may not be the right person to recast it. With more of his time being spent on the racecourse, he’s not as hungry for success as he used to be.

It all adds up to an unusual problem for shareholders. Harvey Norman’s apparent strengths – its property portfolio and long-term owner manager – are part of the problem not the solution. And neither is likely to be going anywhere anytime soon.

This article contains general investment advice only (under AFSL 282288).